Calculation of contribution for sole proprietor

[Jed Macy]

An integrated profit sharing plan calls for a 5% contribution of total pay plus 5% of pay in excess of the SSWB.

For 2003, an executive participant whose total pay is $224,330.46 gets $15,650; [5% x $200,000 + 5% x ($200,000 - $87,000)].

How much would a sole proprietor get if his SEI were $224,330.46? My calculation which is in the attached acrobat file either gets him an additional $282.50 or has an error in it. Is it correct? If not, why not? Thanks for letting me know.

Calc_SP_Cont.pdf

[WDIK]

The $10,282.50 in your calculation file does not limit compensation to $200,000.

Also, can you integrate at the TWB using 5.00%?

[mbozek]

Why would the contribution for a SE person be any different than the contribution for an employee since the comp in both cases is limited to 200k? The only difference is that the max deduction for a SE person is limited to 20% of net earnings from SE up to 200k while the max deduction for employees is 25% of covered comp.

[Mike Preston]

Yes, you can integrate at 5+5 (think of it as 5.7+5.7 but satisfying the 2 for 1 rule.

I'm not sure I understand your comment, mbozek, about the 20% limitation. It looks like you are saying that in all circumstances the deductible limit for a self-employed person is $40,000. But the limit is $50,000 (for somebody who makes enough), so I must not be understanding what you wrote. Of course, the limit is only applicable to the max deductible, not the 415 limit, which remains $40,000.

[mbozek]

The 415 limit is 40k for both - a SE person needs 200k of NE from self employment (20% x 200) since NE must be reduced by the amount of the contribution under IRC 404(a)(8)(D), whereas an incorporated business owner would need only 160k of income to deduct a 40k contribution. A SE person with 160k in NE can make a deductible contribution of 32k (25% x (160-32= 128)). It really is the same for both- an inc. owner with 200k in profits from business can pay himself a salary of 160k and make a deductible contribution of 40k to a DC plan.

[Mike Preston]

I agree with everything you have said, but I disagree with the conclusion when there are other participants involved. Take a plan that covers two people: HCE making $500,000 and NHCE making $40,000. It looks like you are saying that the maximum contribution to the plan would be: $40,000 for the HCE and $10,000 for NHCE, for a total of $50,000. But the real limit is 25% * ($200,000 + $40,000) = $60,000. That would have to be allocated as: $40,000 to the HCE and $20,000 to the NHCE.

Do you concur with my numbers? If you don't, then I'm still not understanding what you are getting at.

[mbozek]

I usully leave this to the accountants but I thought that the contributions for a SE owner and the employees are calculated separately on the SE person's tax return- The SE person deducts contributions for pension contributions for employees on line 19 of the Schedule C which reduces the net earnings from SE that is reported on line 12 of the 1040 (and also deducts salary). This contribution is based on covered comp. See IRS pub 560, P 14. So if an employee making 40k gets a 25% contribution, a total of 50 k is subtracted from profit of the SE to determine the NE from Self employment. In your example the SE person now has net earnings of 450k for tax purposes to be reported on line 12 of the 1040. The deduction for the Q plan contribution for the SE person is calculated separately and is reported on line 30 of the 1040. Thus the max deduction for a SE person is .25 x (200- 40) = 40k. See worksheet on P 20 of pub 560. Under my calculation the total contribution is 50 k not 60 k, but then I am not an actuary.

[Mike Preston]

But you are a lawyer, and one that has been known to read a Code section or two. Where in 404 does it say that the deduction for the SE and the deduction for the employee(s) should be determined separately? It has nothing to do with the 415 limit being increased to 100%, because the same thing could have been done in reverse, before, with the 15% PS limitation: HCE makes $500,000, EE makes $40,000. ER Contributes 15% of all 404(l) pay, which just happens to allocate more to EE than to HCE (don't laugh, I've seen it). Under your theory, the amount attributable to the EE, which would show up on line 19, would have been limited to 15% of the EE's pay. Sorry, it has never worked that way. The amount that shows up on line 19 on the Schedule C is added to the amount that shows up on the 1040 and that total is then treated as the amount deducted under 404 for the sponsoring entity. Whether that amount exceeds the 404 limit is determined by multiplying 404(l) compensation by 25% today (15% in the example above).

But, then again, I'm not an accountant.

[jevd]

Am I missing something from this discussion. The definition of earned income is in 401©(2):

c) Definitions and rules relating to self-employed individuals and owner-employees

For purposes of this section -

(1) Self-employed individual treated as employee

(A) In general

The term ''employee'' includes, for any taxable year, an individual who is a self-employed individual for such taxable year.

(B) Self-employed individual

The term ''self-employed individual'' means, with respect to any taxable year, an individual who has earned income (as defined in paragraph (2)) for such taxable year. To the extent provided in regulations prescribed by the Secretary, such term also includes, for any taxable year -

(i)

an individual who would be a self-employed individual within the meaning of the preceding sentence but for the fact that the trade or business carried on by such individual did not have net profits for the taxable year, and

(ii)

an individual who has been a self-employed individual within the meaning of the preceding sentence for any prior taxable year.

(2) Earned income

(A) In general

The term ''earned income'' means the net earnings from self-employment (as defined in section 1402(a)), but such net earnings shall be determined -

(i)

only with respect to a trade or business in which personal services of the taxpayer are a material income-producing factor,

(ii)

without regard to paragraphs (4) and (5) of section 1402©,

(iii)

in the case of any individual who is treated as an employee under sections [2] 3121(d)(3)(A), ©, or (D), without regard to paragraph (2) of section 1402©,

(iv)

without regard to items which are not included in gross income for purposes of this chapter, and the deductions properly allocable to or chargeable against such items,

(v)

with regard to the deductions allowed by section 404 to the taxpayer, and

(vi)

with regard to the deduction allowed to the taxpayer by section 164(f).

For purposes of this subparagraph, section 1402, as in effect for a taxable year ending on December 31, 1962, shall be treated as having been in effect for all taxable years ending before such date.

------------------------------------------------------------------------------

The calculation for the ees contribution is based on their w-2 comp or other definition as determined by the plan and deducted by the SE employer on sch C prior to calculating SE contribution.

Again. Am I missing something

[Mike Preston]

I can't tell whether you are missing something or not, because I can't tell what you think you might be missing.

[jevd]

Mike,

I thought the discussion and difference of opinion was the definition of earned income. My understanding is that earned income for the self employed is calculated by subtracting 1/2 the SE tax from the bottom line of Sch C and also then multiplying that number by the contribution conversion factor for SEs subject to the $ limit under 415 to arrive at the contribution amount. The contribution is then subtracted from the prior adjusted number to get the EI. That is the number that is then subject to the 200K limit on Compensation.

At least that is my understanding. I think that is where the difference in the calculation in MBOZEK's example is.

[Mike Preston]

First, I don't agree with the steps you are describing. Second, I think mbozek's example is about "splitting" the deduction such that the amount attributable to the SE person is separately determined. I see no justification for that under 404. He makes a good point that the tax returns seem to be laid out in a manner that leads to his conclusion. I don't disagree with that. But that is just the IRS' desire to see some sort of breakdown. The sum of the two is the actual deductible amount against which the limitations of 404 are measured. You don't do that calculation separately for the SE and for the other folks.

[Guest AnnieP]

I checked the numbers on my SE CALC spreadsheet and came up with a contribution of $15650. You used $215932.50 (the amount remaining after reducing for 1/2 of SET). You have to limit the se comp to $200,000. Participant gets no benefit on the $15,932.50.

[Jed Macy]

AnnieP,

Thanks for the straight forward answer to my question. I now agree with your calculation and see the error of my ways.

And thanks to Mike Preston et all for the rest of the discussion which is interesting and useful.

[Blinky the 3-eyed Fish]

Mike, as with SC, I am not sure exactly of your opinion here, so here is another example of a DC plan. Do you agree with the calc and if not why?

2003 net earned income (prior to any pension contribution) = 200,000

W-2 wages of benefiting staff employees = 300,000

Pension contribution for staff employees = 30,000

Pension contribution for sole proprietor = 32,466

Calculation of compensation

200,000 - 30,000 = 170,000

1/2 of SE taxes = (170,000 * .9235 * .0145) + (87,000 *.062) = 7,670

Net = 170,000 - 7,670 - 32,466 = 129,864

The pension contribution for the staff employees works like any other expense that reduces the NEI and SE taxes.

The total deduction though of 62,466 is what would be compared to the deduction limit of (300,000 * 129,864) * .25 = 107,466

[E as in ERISA]

It looks like the confusion is resulting from the fact that some are discussing 404 deduction limits and compensation limits, while others are discussing plan limits and 415 limits.

I think mbozek's point is that the SE's contribution is a circular calc. You need to know what "SE income AFTER SE contribution" is in order to calculate the SE contribution. You convert it into a straight calc by dividing the contribution rate by one plus the contribution rate (.25/1.25 = .20) Then you multiply that percentage by the SE income BEFORE SE contribution." His other point is that the other employees' contribution is a "known" factor that is already included in the "SE income BEFORE SE contribution," so it isn't included in this calculation.

However, one issue I have is that the 401(a)(17) limit is a limit on the net "SE income AFTER SE contribution." So you can apply your "circular calc percentage" to a number in excess of $200,000. E.g., if the "SE income BEFORE SE contribution" is $240,000 and the plan has a rate of 20%, you can apply the "circular calc percentage" of 16.67% to the $240,000 to get a contribution of $40,000. You then test to make sure that your "SE income AFTER SE contribution" is equal or less than $200,000 ($240,000 - $40,000 = $200,000). If not, you skip the circular calc and just multiply the plan rate by $200,000.

So I think that I understand Mike Preston's point as well. I think that his main point is the application of a stated across-the-board (nondiscriminatory) plan rate and the 415 limits. I think that he's just ignoring the circular calc -- which you will generally end up doing when "SE income before SE contribution" is higher. E.g., if the plan has a stated rate of 25% across-the-board and "SE income BEFORE SE contribution" $250,000 or more and there is one employee with $40,000 compensation, then I think that you could actually get to his result. The required total contribution under the terms of the plan could actually be $60,000. The contribution is 25% of plan compensation ($200,000 + $40,000). That calculation doesn't violate 401(a)(17), because no more than $200,000 was taken into consideration for the SE. It doesn't violate 404, because the contribution did not exceed 25% of compensation. You only have a violation when you do the 415 test. The SE would have initially received $50,000 and exceeded the $40,000 limit. But it's not elective deferrals, so it doesn't come out of the plan. It either gets reallocated to the other employee (so he gets $20,000 total) or it gets held in suspense.

The point is not to have stated rate of 25% in this situation.... In most cases like this, you would have different contribution formulas for the employees and SEs and perform discrimination testing.

[Mike Preston]

Blinky, your example is fine, as far as it goes. To make the point a bit clearer, let's raise the $32,466 to $40,000. The net earnings for the Sole Proprietor are modified to be: $170,000 - $7670 - $40,000 = $122,330. Then the deduction is the sum of $30,000 + $40,000 = $70,000 which is less than 25% of the sum of $300,000 + $122,330, which is $105,582.

As I understand mbozek's point, in your example, the Sole Proprietor would be limited to $32,466, because anything higher would result in a deduction FOR THE SOLE PROPRIETOR'S BENEFIT of something in excess of 25% of his/her net earnings. I don't agree with that and that is why I extended your example to make the point clear. (I hope).

[Mike Preston]

Katherine, you make an excellent point, but I don't think I was heading there (except maybe accidentally). I rarely, if ever, have plans where a contribution is made which would intentionally exceed 415. I understand the scenario, though, and agree that it is possible. And I agree that the result is the establishment of a $10,000 suspense account to be allocated in the next limitation year.

In most cases, I'm dealing with different percentages between the sole proprietor and the others. So, look at Blinky's example, which starts out fine by providing a different percentage for the Sole Proprietor ($32,466 / $129,864 = 25.00%) than for the others (10%), but increase it even more, to 32.698%.

My contention is that the $40,000 allocation doesn't violate 415 and it doesn't, when considered with the contributions for the others, violate 404.

Of course, in order to implement this scenario you need some mechanism to allow for different benefit percentages. Either separate plans or a single plan that provides for multiple benefit levels.

[E as in ERISA]

How did you get a 50% ($20,000) contribution for the employee with $40,000 compensation?

[Blinky the 3-eyed Fish]

Yes Mike that is clearer. I too agree that if in my example the sole proprietor got $40,000, that would be fine for 415 and 404. I had picked a 25% allocation randomly.

[Mike Preston]

Katherine, there is nothing that prohibits a $20,0000 allocation to a participant that makes $40,000. The 415 limit these days is the lesser of 415 compensation or $40,000 (in 2003). For somebody that makes $40,000, both parts of that determination are the same dollar amount: $40,000.

So, one way that such an allocation might be possible is if the plan divides the participant population into groups for purposes of determining entitlement to employer contributions. If there is a group that the employer wants to provide with an allocation of 50% of compensation, that is certainly ok.

The only restrictions are non-discrimination and deductibility.

There are many situations where it would not be discriminatory to provide such an allocation.

[E as in ERISA]

I know there is nothing that prohibits an SE from using the other $10,000 of his deduction to provide an extra $10,000 of benefits to NHCE. Didn’t my examples prove that??!?!

But why would he SE do that intentionally? The cost ($10,000) is greater than the tax benefit ($4,500).

The maximum CONTRIBUTION is not determined solely by 404 and the discrimination rules. The plan terms, 401(a)(17), 415, etc. also limit your maximum CONTRIBUTION. And I’m not quibbling here. One of the most important things with SE plans is to know how to simultaneously apply all of those rules and define an optimal contribution formula.

So in most (all?) cases where the SE’s allocation is limited to $40,000, the plan terms will limit the maximum CONTRIBUTION to an amount less than the maximum DEDUCTION.

Your example was as follows:

Take a plan that covers two people: HCE making $500,000 and NHCE making $40,000. It looks like you are saying that the maximum contribution to the plan would be: $40,000 for the HCE and $10,000 for NHCE, for a total of $50,000. But the real limit is 25% * ($200,000 + $40,000) = $60,000. That would have to be allocated as: $40,000 to the HCE and $20,000 to the NHCE.

The suggestion that any plan would have a formula that gave the NHCE in this case a $20,000 allocation seemed crazy. But I was actually helping you out…. I proved that it was NOT impossible. There could be a plan with 25 to 50% contribution rate plus a 415 correction method where the excess would go to the NHCE in the current year. (And the SE doesn’t have to be insane. This could happen where an SE had lower compensation in earlier years and neglected to change the percentage when compensation increased…).

If you don’t like my suggestions, do you have a better way to clarify your example so that not only the maximum DEDUCTION but also the maximum CONTRIBUTION under the TERMS OF THE PLAN would be $60,000? (And the SE doesn’t appear insane)

[Mike Preston]

I fully admit that it looks crazy. However, there are circumstances where it can make sense. Just some examples: 2 person plan with second person being the owner's relative (spouse, parent) with compensation of $40,000. A favored NHCE, such as a son-in-law or brother. Especially if, in the absence of the benefit, the individual might clamor for compensation such that they would end up being an HCE. It can work in any situation where an NHCE wants to trade benefits for compensation (I know one has to be careful of the deemed CODA minefield).

In any of these situations, the terms of the plan must make it clear how this sort of disparate allocation is accomplished. Whether it is a tiered plan design or a reallocation of 415 excess, the result is all that matters.

I'm sure there are others, but that is just a top-of-the-head list.